California Personal Auto Rating Plans

1. California Personal Auto Rating Plans The Good, The Bad and The Ugly Kelleen Arquette

2. Agenda • California Private Passenger Automobile Regulations • Background – Proposition 103 • New Regulations • Market Impact • Pumping and Tempering • Market Studies • Industry Comments • Lessons from Other States • What Can Companies Do? • Other Regulations

3. Background – Proposition 103 • Enacted in 1988 • Requires premiums based on certain variables in a certain order • Three Mandatory Factors • Driving Safety Record • Annual Mileage • Years of Driving Experience • Optional Rating Factors • Some can be combined with Years of Driving Experience • Only approved list allowed • Mandatory rate decrease • Average weight of optional factors below third mandatory factor • Requires rating plan factors to be developed using sequential analysis • Territorial Restrictions • 10 frequency bands and 10 severity bands

4. New Regulations • Enacted July 14, 2006 • Required each insurer to cap the amount of spread an insurer can use for territorial rating • 20 frequency bands and 20 severity bands • Although more bands allowed, restriction on weight limits territorial dispersion • Required each insurer to file an updated rate level indication • Weight of each optional factor below third mandatory factor • Two phases • First filing within 30 days – move part way towards full compliance, including rate filing • Second and subsequent filings – achieve full compliance within two years

5. Implementation – Phase One • First filing required to correct for any non-compliance by 15% • For any factor with weight above the third mandatory factor, decrease the weight by 15% • Initial filings did not accomplish full compliance for factor weights • Frequency and severity bands • Gender and marital status in some cases

6. Implementation – Phase One (continued) • Auto Club (Interinsurance Exchange of the Auto Club) • First to file • 7.0% decrease • Weights for multi-car, gender for a few coverages, frequency bands and severity bands still above third mandatory factor • Retained current frequency and severity band definitions

7. Implementation – Phase One (continued) • USAA • Second to file • 5.1% decrease • Weight for frequency band factors still above weight of third mandatory factor • Retained current frequency and severity band definitions • Reduced weight of frequency band factors by lowering the relativities for the highest rated bands and increasing the relativities for lowest rated bands, instead of tempering

8. Implementation – Phase One (Continued) California Market Share Pending Rate Changes • State Farm: -8% • Mercury: +4.5% • Auto Club: -7% • Farmers: 0% • Allstate: 0% • AIG: -5% • California State Auto: -5% • Progressive: -2% • USAA: -5% • GEICO: -5%

9. Implementation – Phase Two • Full compliance with proposed regulations must be achieved by July 14, 2008 • Requires at least one filing – rate and class plan • Redefine territory definitions to 20 territories • Number of filings will depend on • Customer rate impact • Customer retention • Rate indication • Competition

10. Pumping and Tempering • Factor weight • Weighted average of the absolute difference of the relativities from the mean • Measure of dispersion • Temper – lessens dispersion, decreases factor weight • Pump – increase dispersion, increases factor weight • Example • Driving Safety Record 10 • Annual Mileage 9 • Years of Driving Experience 8 • Frequency Band 13 • Possible solutions • Select different relativities to align weights • Temper frequency band relativities • Pump years of driving experience, annual mileage and driving safety record

11. Pumping and Tempering (continued) • Cross-subsidies • Pumping Driving Safety Record – Drivers with accidents and convictions pay too much, high surcharges may create incentive for unreported minor accidents • Pumping Annual Mileage – Long annual mileage drivers subsidize short annual mileage drivers, incentive for policyholder to underestimate annual mileage • Pumping Years of Driving Experience • Higher rates for new drivers increases likelihood of undisclosed drivers • Increase uninsured population of new drivers (<9 years driving experience) and experienced drivers (59+ years of driving experience) • Temper Cost and Frequency Bands – Urban rates subsidized by suburban and rural rates • Temper Gender/Marital Status – Rates for inexperienced single male drivers subsidized by other drivers

12. Pumping and Tempering (continued) • 2003 study ranked importance of rating variables • Three most important factors connected to loss propensity do not align with California’s Three Mandatory Factors • Insurance score is not an optional factor in California • Years of driving experience used in California instead of age Source: The Relationship of Credit-Based Insurance Scores to Private Passenger Automobile Insurance Loss Propensity, Michael Miller, FCAS and Richard Smith, FCAS, Epic Actuaries, June 2003

13. Market Studies – Robert Downer Study • Study commissioned by Personal Insurance Federation of California (PIFC) and Association of California Insurance Companies (ACIC) • Study performed by Robert Downer of ARM Consultants, Inc. • Data from four large auto insurers • Study focused on rate changes for individual drivers rather than rates relative to indicated costs • Study assumed revenue neutral changes • Study shows • Over 60% of all drivers will receive a rate increase • Nearly 75% of drivers with 34 years driving experience (50+ years old) will receive rate increases • Over 60% of California Good Drivers will receive rate increases • Over 55% of drivers not considered California Good Drivers will receive rate decreases Source: Personal Insurance Federation of California Reference Book, “Impact of petition to modify use of Optional Rating Factors”, Robert Downer

14. Market Studies – Mercer Oliver Wyman Study • California Department of Insurance commissioned study by Mercer Oliver Wyman • Participation from several companies • Three instruction sets completed by participating companies, data provided to Mercer Oliver and Wyman for analysis • Study focused on rate changes for individual drivers rather than rates relative to indicated costs • Study assumed revenue neutral changes • Study shows • Rate increases for 52 of 58 counties • Approximately 60% of California drivers would receive a rate increase • 27% of all drivers will get a rate increase of over 10% • Rural drivers subsidize urban drivers • Magnitude of cross-subsidies range from $344 million to $742 million • Two studies show same results – New regulations will result in rate changes for drivers across the state • Rate changes not considered in either study Source: California Farm Bureau Federation Fact Sheet, “Proposed Amendment of Title 10 California Code of Regulations, Section 2632.8 – Optional Automobile Insurance Rating Factors” Californians to Stop Unfair Rate Increases, “Two Different Studies – Same Conclusion, Department of Insurance Proposal Will Result In Higher Auto Insurance Rates for More Drivers?”

15. Industry Comments – 45 Day Comment Period • Insurer comments during 45 day comment period prior to passage of new regulations • Rates should be cost-based and substantially related to the risk of loss • A driver’s location (zip code) should be a critical factor in calculating insurance rates • Drivers in rural regions of the state should not be forced to subsidize the rates for drivers in urban regions of the state • The proposed regulations will result in arbitrary rates because of the act of pumping and tempering and the resulting cross-subsidies. Pumping and tempering move rate relativities in opposite direction of indicated

16. Lessons from other states - Michigan • Michigan Essential Insurance Act • Take-all-comers provision • Territory restrictions • 20 territories • Maximum 10% rate differential between adjacent territories • Restrictions on maximum rate differential between highest and lowest rated territories (lowest rated not less than 45% of highest rated) • Market Impact • Urban territories subsidized by suburban and rural territories • Insurers specialized in urban or rural areas, with rates that reflected their market area • Coverage availability problems in Detroit • Increase in the involuntary market, especially in Detroit • Similarities to California Regulations • Territory restrictions that create a subsidy for urban drivers • CA insurers must accept all California Good Drivers Source: Mackinac Center for Public Policy, www.mackinac.org, “The Essential Insurance Act”

17. Lessons from other states - Massachusetts • State-mandated rates • Territories • Territory definitions are re-defined every two years • Urban territories subsidized by rural territories • 27 territories • Age, gender and marital status prohibited • Mandatory Offer Rule • Tempering and capping • Exit restrictions • Reallocation of premiums across insurers based on loss experience Source: Chapter 2 “Automobile Insurance Regulation: The Massachusetts Experience” Sharon Tennyson, Mary A. Weiss, Laureen Regen

18. Lessons from other states – Massachusetts (continued) • Market Impact • Cross-subsidies – urban territories subsidized by rural territories, inexperienced drivers subsidized by experienced drivers • Massachusetts auto insurance market less profitable than the U.S. auto insurance market overall • Increase in residual market • Fewer firms in the market compared to other states • Shift to Massachusetts-only firms • Cross-subsidies distort consumer behavior • Insurance premiums charged do not reflect true cost of providing insurance • Greater relative participation of high risk drivers in the driving and insuring population, increasing average expected costs • Companies specialize in urban or rural markets • Regulations lead to higher insurance costs Source: Chapter 2 “Automobile Insurance Regulation: The Massachusetts Experience” Sharon Tennyson, Mary A. Weiss, Laureen Regen National Association of Mutual Insurance Companies press release, “Study supports NAMIC Position That Massachusetts Over-Regulation Leads to Higher Insurance Costs”, April 30, 2004

19. Lessons from other states – Massachusetts (continued) • Proposed legislation in 2006 to revise auto system. Although not passed, work is ongoing to build support • Similarities to California market • Territorial restrictions • CA insurers must accept all CA Good Drivers • Pumping and tempering • Complex system of cross-subsidies • Difference from the California market • No mechanism for reallocation of premium Source: Chapter 2 “Automobile Insurance Regulation: The Massachusetts Experience” Sharon Tennyson, Mary A. Weiss, Laureen Regen National Association of Mutual Insurance Companies press release, “Study supports NAMIC Position That Massachusetts Over-Regulation Leads to Higher Insurance Costs”, April 30, 2004

20. Conclusions • Cross-subsidies • Reduce incentive for companies to write subsidized drivers • Insurance premiums charged do not reflect true cost of providing insurance • Greater relative participation of high risk drivers in the driving and insuring population, increasing average expected costs • Companies specialize in rural or urban markets • Higher insurance costs • Auto insurance market less profitable than U.S. auto insurance market • Rate increases for rural and suburban drivers • Rate changes across the state • Consumer shopping

21. What can companies do? • Diligent data collection for accurate rating • MVR reports – must balance with cost of MVR ($ ) • Annual mileage • Undisclosed drivers • Misclassification lowers factor weights • Underestimation of annual miles lowers the factor weight for annual mileage annual mileage

22. What can companies do? (continued) • Redefine cost and frequency bands – geographic clustering • As major competitors make class plan filings, include competitive review and make adjustments to proposed class plan • Maximize use of optional rating factors

23. What can companies do? (continued) • Optional Rating Factors • Type of vehicle • Vehicle performance capabilities (including alterations) • Type of use of vehicle (pleasure, business, commute, etc.) • Percentage use of the vehicle by the rated driver • Multi-vehicle households • Academic standing (Good Student Discount) • Driver training or defensive driving courses • Vehicle characteristics (protective devices, theft deterrent devices) • Gender • Marital status • Persistency (renewal discount) • Non-smoker • Secondary driver characteristics (safety record, years licensed, gender, marital status, driver training, academic standing for drivers not assigned as primary or secondary drivers on another vehicle) • Multi-policy discount • Relative claims frequency • Relative claims severity Source: California Insurance Regulations, Title 10, Chapter 5, Subchapter 4.7, Section 2632.5

24. What can companies do? (continued) • Years of driving experience can be combined with • Percent use • Academic standing • Gender • Marital status • Driver training • Analyze rating factors used by competitors • Household Composition Factor (Allstate) • Liability Symbol (Allstate) • Model year for liability coverages in addition to liability symbol (Auto Club) • New Vehicle Discount (USAA) • Multiple Policy Discount (State Farm) • Garaging location for comprehensive coverage (Auto Club) • Persistency Discount (several insurers) Source: California Insurance Regulations, Title 10, Chapter 5, Subchapter 4.7, Section 2632.5

25. What can companies do? (continued) • Sequential Analysis • Order of optional factor • Driving Safety Record (first), Annual Mileage (second), Years of Driving Experience (third) • Cost and Frequency Bands (last) • Multivariate analysis to compare proposed to indicated

26. Other Regulations • Regulations on the Horizon • Annual Mileage Regulations • Prior Approval Regulations

27. Regulations on the horizon – Annual Mileage • Proposed regulations • Estimated annual mileage (new business or added vehicles) • Based on policyholder estimate • May use reasonable estimate if policyholder’s estimate is not available • Calculation • Distance to/from work, number of days driven to work • Difference between estimate and prior 12 months • Verification (renewal business) • Odometer reading from insured • Service records (insurer can’t require) • Technological devices provided by insurer • Smog check odometer readings • New business – cannot request annual mileage from prior carrier Source: CDI Proposed Regulation Text, Mileage Verification, Section 2632.5

28. Regulations on the horizon – Annual Mileage (continued) • Association of California Insurance Companies’ response to proposed annual mileage regulation • Insurers should be allowed more flexibility in estimating annual mileage • Annual mileage verification should be allowed on new business • High potential costs to insurers as regulations may require collection of annual mileage information from current book Source: Statement of the Association of California Insurance Companies on “Proposed Amendments of Section 2632.5”, June 2006

29. Regulations on the horizon – Annual Mileage (continued) • “Black Box” rating (telematics) • Potentially provides information to car makers (and insurers) through on-board sensors, Global Positioning Units (GPS) units and mobile phone technology • GM announced telematics will be standard on all GM vehicles by 2007 (and has been standard for Mercedes-Benz and BMW) • If cost and potential legislative barriers are overcome, could provide exact annual mileage • Progressive has been piloting a system in Minnesota since 2004 and Texas since 1998

30. Regulations on the horizon – Prior Approval Insurance Regulations • Prior Approval Regulations • Specifies methodology for developing rate indication • Loss Development – dollar-weighted average of last three link ratios, no tail factor • Trend – company’s latest 12 quarters of calendar year paid claim cost and frequency data, developed using exponential curve of best fit • Efficiency Standard – maximum allowable expense ratio set by insurance commissioner, three-year average expense ratio • Leverage Factors and Surplus – allocation based on loss and unearned premium reserves • Credibility – current rate plus a trend • Catastrophes – historical experience only, no external data • Limited scope for variance requests Source: Proposed Regulation Text 2642.4 – 2648.4

31. Regulations on the horizon – Prior Approval Insurance Regulations (continued) • Association of California Insurance Companies – “Comments on Proposed California Prior Approval Insurance Regulations”, Michael A. Walters • Unprecedented degree of prescription – no ratemaking methodology is appropriate in all cases • Removes actuarial judgment • Methodology • Input • Result – cause operating losses or inadequate returns for insurers and lines constricted by simplistic rate indication approach • Recommendation – proposed procedures guideline for simplistic approach, identify filings that need more attention Source: Michael A. Walters, Tillinghast report to the Association of California Insurance Companies, September 13, 2006

32. Questions?